Fragile Eurozone 2013
1
The Fundamental Trilemma
Country can choose only two the three objectives: fixed
exchange rate, open financial markets, or monetary
independence:
1. Country can have fixed exchange rate and retain monetary
policy. But this would require maintaining controls on financial
flows.
- China today and early Bretton Woods;
2. Country can leave financial movements free and retain monetary
autonomy, but only by letting the exchange rate fluctuate.
- Eurozone, Japan, UK, US
3. Country can have open financial markets and stabilize the
currency, but only by abandoning monetary policy as
countercyclical tool.
- Argentina yesteryear, individual countries of Euroland, Hong
Kong
2
The Small Mundell-Fleming Economy with Fixed Rates
Goods market
Same as before but with fixed exchange rate (R*)
(Expfx)
Y = C(Y - T) + I(rd) + G + NX(R*)
Financial markets
Monetary policy equation in small open economy with risk premium (σ).
(MP$)
rd = rw + σ
Substituting MP$ into Expfx:
(IS$fx)
Y = C(Y - T) + I(rw+ σ) + G + NX(R*)
In Eurozone, real exchange rates only move with domestic prices.
R = e*pd/pf
So the evolution of competitiveness depends upon relative inflation (or
production costs).
3
Cases to think about
•
•
•
•
Fiscal policy
Monetary policy
Divergent inflation in Eurozone
Financial shocks or risk premia for southern
Europe in Eurozone
4
rd
OPEN ECONOMY
Equilibrium
rw+σ
MP$fx
C+I(rw+σ)+G+NX(R*) (IS$fx)
Y
5
rd
Fiscal policy
rw+σ
MP$fx
(IS$fx)
(IS$fx)’
Y
6
rd
Monetary Policy
rw+σ
MP$fx
(IS$fx)
Y
7
Results with Fixed Rates are
Reverse of Flexible Rates!
• Fiscal policy super-effective
• Monetary policy super-ineffective
• Like a liquidity trap!
8
History of Eurozone
-
Gold standard through 1914, suspended WW I, reinstated 1920s.
Long civil war in Europe (1914 – 1945).
Gold standard deepened the Great Depression
Reconstruction with Bretton Woods system (1945- 1971)
European leaders desired economic and political integration to
reduce prospect of future wars
Common Market and European Community (1958 – 1993)
European Monetary System (1978 - 1988): fixed rates of major
countries
Delors plan for monetary union (1989)
Eurozone established with irrevocable fixing of rates (2001)
EZ adopted by 17 countries as of 2013
Divergent wage trends led to growing imbalances after 2001
World financial crisis 2008 weakened public finances
Eurozone crisis begins in Ireland, spreads to Greece, then to Italy
According to Euroskeptics, the end of the Eurozone is nigh…
9
Eurozone 2013
10
Costs and adjustment in Eurozone
• Because e is fixed, only adjustment by relative prices (pd/pf).
• We can see the growing divergence by looking at unit labor
costs (ULC).
ULCi = wi/(Productivityi)
• Next slide shows how south because increasingly
uncompetitive, real appreciation.
• Led to German R depreciation, big current account surplus,
boom; opposite in the South.
• Major issue of EZ is that only options for adjustment are
inflation in the north or prolonged high unemployment and
deflation in the south.
11
Unit labor costs relative to EZ average (1998 = 1)
1.5
1.4
1.3
Greece
Spain
Italy
France
Germany
Austria
1.2
1.1
1
0.9
0.8
0.7
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
12
rd
Inflation in Italy, raising R, lowering NX, Y
rw+σ
MP$fx
(IS$fx)’
(IS$fx)
Y
13
Unstable dynamics
See Romer reading.
Good example of “bad equilibrium, good equilibrium”
like bank runs (here, runs on countries whose liabilities
are in foreign currencies).
Why is Spain in trouble but not UK?
14
Romer debt model
Basic ideas:
- This is the run on the bank as applied to countries.
- Basic idea is that have an instability because of the impact of
risk on country interest rates (rd = rw + σ).
- Two equilibria: good (full employment) and bad (default)
Assumptions:
- Government has debt of D and default probability π.
- Governments have a random tax revenue, T, with cdf F(T).
- Interest:
R  1  r  (1  r ) (1-  )  R(1-  ), where r = risk-free rate.
R  (R  R) / 
- When T < RD, the government defaults
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Math of Romer model
- Investor equilibrium:
  (R  R) / R
- Government default occurs when T < RD, which has a
cdf (cumulative distribution function):
  F ( RD )
- We have two equilibrium equations in R and π.
16
π
(prob. of
default)
1
  ( R  R) / R
Investors
0
R
R (interest factor)
17
π
(prob. of
default)
1
  F ( RD )
Government
and taxes
0
R
R (interest factor)
18
π
(prob. of
default)
1
Investors
Government
and taxes
0
R
R (interest factor)
19
π
(prob. of
default)
Three equilibria
1
Investors
Government
and taxes
0
R
R (interest factor)
20
π
(prob. of
default)
UNSTABLE DYNAMICS
1
Investors
Government
and taxes
0
R
R (interest factor)
21
π
(prob. of
default)
1
Simplified if T is given
Government
and taxes
Investors
0
R
R (interest factor)
22
Greece: before and after the run
•
•
•
•
•
Viewed as riskless until financial crisis
Risk first perceived in financial crisis (1)
October 2009: Greek fiscal situation announced much worse (2)
Fall 2009: Greek debt downgraded
Early 2010: Greek asks for voluntary default (3)
14.00
Spread on Greek Debt
3
12.00
10.00
8.00
2
1
6.00
4.00
2.00
0.00
2005
2006
2007
2008
2009
2010
2011
23
Italy: before and after the ECB intervention
•
•
•
•
Viewed as riskless until financial crisis
Deterioration as Euro crisis progressed (1)
Spiral toward bad equilibrium (2)
July 2012: ECB announced it will “do whatever it takes” to save Eurozone (3),
leading to improvement (movement toward good equilibrium)
6
Spread on Italian Debt
3
5
2
4
1
3
2
1
0
2005
2006
2007
2008
2009
2010
2011
2012
2013
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rd
Increased risk, raising rd
MP$fx’
rw+σ
MP$fx
(IS$fx)
Y
25
Summary on Romer model
- Another example of a runs model with two equilibria
- Can help understand why:
- Some countries are crisis-prone
- How a rescue operation can move country to a good
equilibrium
26
Options for Eurozone
1. Rapid Growth of Eurozone
–
–
ECB lowers rates, Euro depreciates, Germany expands
Problem: in liquidity trap, almost out of bullets
2. Long Recession to Restore Periphery Competitiveness.
- Austerity in periphery to lower costs and pricesDoesn' and their
R
- Problem: economic misery and political instability in the south
3. The Core Permanently Subsidizes the Periphery
(“transfer union”)
- Problem: Germans just say no
- Germans don’t want to subsidize rich Southerners
4. Widespread Debt Restructurings and EZ breakup
- Probably best solution … if could figure out how to do it.
- Problem: Hard to predict impact? world financial meltdown?
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Bottom line this week
• Exports and imports affect aggregate demand,
particularly for very open economies.
• Openness is growing in trade and finance.
• Exchange rates are the monetary link among countries.
• In the open economy, the tail wags the dog
(tail = financial flows; dog = trade balance).
• US has a chronic trade surplus because people love to
put their money here (central banks and investors).
• Countries face a trilemma among fixed exchange rates,
domestic monetary policy, and open financial markets.
• Europe has made a fateful choice in the trilemma that is
devastating the continent with no end in sight.
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